Forecasting with Price Elasticity of Demand

Economics is not an absolute science. Unlike the more empirical fields of physics or chemistry, economics has to factor in a lot of human qualities and behavior that is, at times, fairly unquantifiable. So economists have to do their best to predict the likelihood of an event occurring based upon the given data at a particular moment in time.

One example of this forecasting of behavior that economists attempt is the price elasticity of demand. The price elasticity of demand attempts to determine the percentage change in the quantity demanded of a particular good or service when the price of that good or service changes by a certain percentage.

Key Takeaways

• The price elasticity of demand attempts to determine the percentage change in the quantity demanded of a particular good or service when the price of that good or service changes by a certain percentage.
• When a good or service is considered to have perfectly elastic demand, a change in price would eliminate all demand for the product.
• Relatively elastic demand means that there will be more change in the quantity demanded of a good or service than in the price of that good or service.
• Perfectly inelastic demand means that regardless of price, the quantity demanded of a good or service remains constant.
• Relatively inelastic demand means that there will be more change in the price of a good or service than in the demand for that good or service.

For example, if you are shopping for an airplane ticket to New York City, you may discover that there are 20 flights from your town to New York City and all of them have the same price except for one. Airline Bumpy Ride is charging $30 more for its flights than its industry competitors. Everything about the 20 flights is identical: same in-flight meals, the same departing and arriving times, and they all offer free baggage check-in. The management at Bumpy Ride wants to test the competitive landscape of the airline industry and gauge what happens to their business if they raise prices by $30 on all flights to New York City. How many people will be willing to pay the additional $30 to book a flight to New York City through Bumpy Ride?

Most rational individuals would not decide to pay more for a Bumpy Ride flight. Given the variety of airlines to choose from and the identical value propositions, demand is said to be perfectly elastic in this scenario: the quantity demanded of airplane tickets from Bumpy Ride will drop down to zero with an increase in price. Economists call this perfectly elastic demand. The chart below illustrates perfectly elastic demand.

Perfectly Elastic Demand

Relatively Elastic Demand

Relatively elastic demand means that the quantity demanded of a good or service will be impacted by a price change in that good or service. Typically, a good or service is said to have high price elasticity when many substitutes for that good exists.

For example, as you walk down the aisle at a grocery store, you may notice pure sugar as well as many other sugar substitutes. If the price of pure sugar increases tomorrow by $2 per bag, would you be willing to pay an additional $2 for a bag of sugar when they are sugar substitutes? Most people would shift their preferences from pure sugar to a sugar substitute, thereby reducing their quantity demanded of pure sugar.

Most economists would agree and therefore consider sugar a highly elastic good. The figure below illustrates the considerable reduction in the amount of sugar demanded as its price increases.

Notice the decline in the quantity demanded of sugar as the price increases. The steep downward slope in the quantity of sugar demanded illustrates that demand for sugar is relatively price-elastic. The change in quantity demanded exceeds the change in price on a relative basis.

Perfectly Inelastic Demand

In theory, perfectly inelastic demand means that regardless of price, the quantity demanded of a good or service remains constant. Think about that; is there a good or service that you would pay any amount for?

Most people with a terminal illness would pay any amount for a known cure for their disease. Most people would pay any price for water. However, bottled water is relatively price elastic because tap water is in plentiful supply and is practically free. The figure below illustrates perfectly inelastic demand.

Relatively Inelastic Demand

One example of a good that is considered relatively price inelastic is gasoline. Businesses and consumers both require gas to thrive in this economy. Despite the movement towards alternative fuels, many people who are dependent upon gasoline in their daily lives and are neither likely nor capable of switching to alternative fuels as a practical substitute.

If gasoline prices increased 30% tomorrow, would you not go to work? Most people will pay a higher price out of necessity. Of course, there are exceptions. During the oil and gas bubble of 2008, prices soared to a national average peak of approximately $4.10 a gallon and people changed their behavior by demanding less gas. Some economists felt this demand shift contributed to the severe recession that followed in late 2008 and 2009. In a normal market, gas is a relatively inelastic product as the figure below illustrates.

Gas is highly price inelastic. Demand remains relatively consistent despite any increases in the price. The reduction in demand is smaller than the increase in price on a percentage basis.

Conclusion

Price elasticity of demand is how economists try to measure demand sensitivity as a result of price changes for a given product. This measurement can be useful in predicting consumer behavior as well as forecasting major events, such as an economic recession or recovery. As consumers, we make decisions that economists measure on a daily basis. If the price of a good increases and we can live without it, or many substitutes exist, then we consume less of it or maybe none at all. Water, medicine, and gasoline are necessities that, despite price increases, we will still demand in great quantities.

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